With WTI hovering at roughly $45 per bbl, Saudi Arabia’s ongoing struggle to maintain its share of the global oil market seemingly shows little sign of winding down. On the face of it, Saudi Arabia’s strategy makes intuitive sense: leverage its substantial production capacity to flood the market with crude oil and drive down the price to the point where rival shale production at current levels is uneconomical.
True enough, US rig counts continue to drop and without a doubt production targets will be revised downward for the coming year. With cash flow down, more leveraged operators look more vulnerable than ever. Some may not survive the downturn.
If we talk about breakeven pricing in a simplistic sense, i.e. where revenue equals the nominal cost of producing a barrel of oil, then Saudi Arabia has a massive advantage, with production costs at $21 per bbl, compared to US producer breakevens typically in the $40 to $60 per bbl range, depending on the resource play.
For context, Canadian oil sands operations face WTI breakevens of $16 to $51 per bbl and $34 to $54 per bbl for in situ and mining projects, respectively.
At $45 per bbl, Saudi Arabia’s position looks quite enviable on the surface.
Breaking down breakevens
In general, what the breakeven price level is depends on the costs factored.
Simple accounting breakeven factors in production-linked expenses – including taxes – and also transportation, exploration, and DD&A expenses. For example, assuming the per barrel cost of each of these aforementioned expenses is $13, $3, $3, and $1, then the breakeven price would be $20 per bbl. Additional costs can be factored in, such as finding & development costs as well as the weighted average cost of capital (WACC).
Another way to view breakevens is the price level where producers have an IRR of 0%. At this point, producers merely recover their investment, including the standard assumed 10% cost of capital, over the potentially decades-long life of the project.
Put simply, breakeven pricing in relation to oil & gas as a business is relatively fixed in meaning. It does not deviate fundamentally from the common understanding of the term, although there is room for nuance.
Confining breakevens to such parameters makes no sense when discussing this price war, because comparing US producers’ breakevens to those of Saudi Arabia is like comparing apples to oranges.
Why Saudi Arabia is an orange
Unlike the US, there is no meaningful separation between the Saudi state and the Saudi oil industry. The state-owned oil company, Saudi Aramco, is effectively the sole operator, although Saudi Arabia has allowed some foreign companies to participate in the development of natural gas projects as well as some upstream assets. For lack of a better word, Saudi Arabia is a true petrostate. In 2014, the crude oil sector comprised a whopping 43% of GDP.
It does not do to simply look at accounting breakevens where Saudi Arabia is concerned. All states have spending needs. Since the Saudi state and the Saudi oil & gas industry are the same, the Kingdom’s breakeven price has to factor in fiscal requirements. Taking these into account, Saudi Arabia needs Brent pricing at roughly $105 per bbl to balance its budget. Qatar’s $80 per bbl fiscal breakeven looks good in comparison.
In part then, goals determine breakevens. At breakeven pricing, US producers will not turn much of a profit. However, so long as there is a prospect for an upswing, they will tough it out. In the interim, companies will bat down the hatches and aim to reduce costs.
Indeed, shale play breakeven costs have been trending downwards over the past few years, as is not atypical once projects gather full steam.
Moreover, global trends point to more demand and tighter supply.
Increasing economic growth and urbanization in the developing world points to upward trends in demand. As does demographic growth. By 2050, for example, Africa’s population is projected to double to 2.5 billion. The implications for energy demand are obvious.
Meanwhile, Saudi Arabia is pushing its spare production capacity to its limits. For context, global spare capacity in 1980 was 15 mmbbl/d. The figure in 2015 is 2 mmbbl/d. True, Saudi Arabia has low-cost, easily developed and easily refined crude. But given its limited spare capacity, it needs $100 per bbl to economically add new fields. Even then, it cannot quickly respond to growing demand. By comparison, US production is projected to grow at a healthy pace despite current low prices.
Granted, Saudi Arabia has breathing room with plenty of foreign assets to sell, $670 billion in foreign cash reserves, and a debt-to-GDP ratio of only 1.6%. Yet, there are signs that the Kingdom’s finances are experiencing some strain. 2015 government spending and revenue sits at $229 and $191 billion, leading to a $38 billion budget deficit, almost three times that of the prior year. In this context, it is understandable that the country is potentially looking to take on $27 billion in loans.
Of course, the Kingdom has no income tax. Conceivably, even a modest tax could close the deficit. But that would touch on stability issues.
Traditionally, government largesse in the form of social programs, job creation, and education spending has been used to maintain stability. That is part of the reason the country emerged largely unscathed from the Arab Spring uprisings. Some observers might be surprised that the country prefers to take on debt rather than raise income taxes, but this choice is entirely consistent with the government’s social contract and desire for stability.
Again, spare capacity is diminishing and further production additions will not be inexpensive. This is a real concern given that Saudi Arabia remains one of the fastest growing countries in the world, with roughly 8 of its 30 million people below the age of 15, a total fertility rate of 2.66 (compared to 1.88 in the US), a life expectancy of roughly 73 years, and a population projected to grow to 37 and 46 million by 2030 and 2060.
This portends serious social challenges. The country faces youth unemployment of 29%, an education system that has failed to meet the needs of private-sector employers, and 1.9 million young people entering the job market over the next decade.
A burgeoning, unemployed, and dissatisfied youth population is a recipe for social upheaval, and given the country’s past crackdowns on Islamist terrorism and several fresh ISIS-linked attacks on the country’s Shia population, the Kingdom looks quite beleaguered.
Indeed, for the time being, the common current is growing sectarianism in the region, with increasing dissatisfaction in the country’s Shia-majority oil-rich provinces.
Perhaps to hedge against growing instability at home while asserting its influence abroad, Saudi Arabia committed $80 billion to defense spending in 2014, outspending its regional rival Iran 5-to-1 and in the process becoming the fifth largest military spender in the world. With the Kingdom bent on checking Iranian influence in Syria through its proxies and in Yemen directly, where its inconclusive campaign is growing steadily more destructive, it certainly appears that the money spent on its new kit is not going to waste.
A price war with the US, a real war with Iran’s allies, and looming social, economic, and security challenges ensure that the Kingdom’s plate will be more than full in the years to come.
What does it all mean?
Breakevens are determined by goals. Saudi Arabia is an ambitious petrostate that faces numerous social, economic, and security challenges, both domestically and internationally.
Currently, its fiscal breakevens are far above the price of oil. But focusing on fiscal breakevens reveals only part of the picture. The Kingdom faces diminishing spare capacity and thus a ceiling on revenue growth at current prices. This is significant considering that 1) its future spending needs will likely increase to accommodate its burgeoning population in order to maintain internal stability and 2) its future defense spending may have to increase in the event that its already tenuous geopolitical position worsens.
It also must be pointed out that domestic social problems in large part reflect the ongoing sectarian tensions in the region, and it makes little sense to divorce the Kingdom’s domestic security concerns from its geopolitical concerns.
Bottomline, whatever Saudi Arabia’s effective breakeven point, it must certainly account for the panoply of social, economic, and security factors that will dictate its future spending requirements. It is likely that the current fiscal breakeven understates the true price of oil needed to successfully plan for the challenges ahead.
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